Does budget austerity boost growth? A decline in interest rates due to a lower probability of default should support investment and asset prices. Expectations of lower future taxes and higher lifetime earnings may encourage investment and spending. A new ECB working paper argues that “a fiscal contraction may turn out to be expansionary if the expectation channel becomes sufficiently strong.” In practice, however, it rarely works out that way. In a recent IMF study of 173 fiscal-policy changes in rich countries from 1978 to 2009, economists from the IMF found that cutting a country’s budget deficit by 1% of GDP typically reduces real output by about two-thirds of a percentage point and raises the unemployment rate by one-third of a percentage point.
Also see the BIS Annual Conference, June 2011 – Fiscal policy and its implications for monetary and financial stability.
The issues were summarised in “Cut or loose: history suggests that austerity and growth just do not mix“, Economist, 14 July 2011